Forward Contracts Explained Simply

8/4/2019 Forward Contracts Explained Simply

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Use of Derivatives by Indian

Exporters

Presentation by FIMMDA to

CBI



Foreign

BuyerIndian

Exporter

Order/LC

For T-Shirts

Shipment after

1 –year.Price $ 10 per T-

shirt

Exporters P/L calculations : T-Shirt Cost = Rs 380 + Profit Rs 10

Export Invoice Price : Rs 390

Exchange Rate as on ……. $ 1 = Rs 39.00 Therefore USD Price per T-Shirt : $ 10



ExporterBank

A

Request for Forward

Contract,

Value 1 year forward



Bank

X

Bank

Y

Bank

A

Bank

Z

Borrow Sell

Rs 37.05

$ 0.95

Deposit/Lend

Rs 37.05

Receive Maturity

Proceeds

Rs 39.25

$ 0.95

1 2

3 4



BankX

BankY

BankA

Bank

Z

Exporter

1$ Bill Rs 39.20 ( 39.25- 0.05)

Sell

$ 0.95

RS 37.05

Borrow

$ 0.95

Repay $ 1.00

Loan + Int

Lend/DepositRs 37.05

Receive maturity

Proceeds incldg IntRs 39.25

1 2

3

4

5

6

Spot Exchange rate 1 $ =

Rs 39.00

Forward Exchange Rate

1 $ = Rs 39.20



3 Months later

Spot $/INR = Rs 35.00 (say)

After the Exporter booking a Forward Contract at 1$ = Rs 39.20 (value 1 year Fwd)

Foreign Buyer cancels the order placed with the Exporter

Bank

ARequest to cancel ForwardContract

Exporter



Exporter

Bank

X

Bank

Z

Bank

YBank

A

Buy

$ 0.96

Rs33.60

Break

depositRs+ Int ( 37.59 )

Prepay $ loan +

Int =$ 0.96 =(Rs

0.50 )

Gain on Cancellation of Fwd Contract: Rs 37.59- Rs 33.60 = Rs 3.99

Less Interest on $ loan converted into Rs = Rs 0.50

Less Bank A’s operating Expenses + margin Rs 0.50

Amount payable to Exporter Rs 2.99

Rs 2.99 ( Gain to Exporter withoutmaking any Exports ! )

1

23

4

Spot Exch Rate

1 $ = Rs.35.00

Spot Exch

Rate :1$=Rs 35.00

1



3 Months later

Spot $/INR = Rs 45.00 (say)

After the Exporter booking a Forward Contract at 1$ =

Rs 39.20 (value 1 year Fwd)Foreign Buyer cancels the order placed with the

Exporter

ExporterBank

ARequest to cancel ForwardContract



Exporter

Bank

X

Bank

Z

Bank

YBank

A

Buy

$ 0.96

Rs 43.20

Break

depositRs+ Int ( 37.59 )

Prepay $ loan +

Int =$ 0.96 =(Rs 0.50 )

Loss on Cancellation of Fwd Contract: Rs 37.59- Rs 43.20 = Rs (5.61)

Add Interest on $ loan converted into Rs = Rs (0.50)

Add Bank A’s operating Expenses + margin Rs ( 0.50)

Amount Payable by the Exporter Rs (6.61)

Rs 6.61 ( Loss to Exporter)

1

23

4

Spot Exch Rate

1 $ = Rs.35.00

Spot Exch

Rate :1$=Rs 45.00

1



IN SUMMARY

A Forward Contract booked by an Exporter seeks to protect his profitabilityfrom his business operations (Export of T-Shirts in the present examples)

As long as the Forward Contract is not cancelled, and the contracted export

takes place, the Exporter does not make any gains/losses on account of the

fluctuations in the foreign currency versus INR (if exports invoiced in foreign

currency

If a Forward Contract(Exports) is cancelled, there could be a gain for the

Exporter , if the foreign currency (vs INR) price depreciates as on date of

cancellation as compared to the spot rate on date of booking the contract.

If a Forward Contract(Exports) is cancelled, there could a loss to the Exporter ,if the foreign currency (vs INR) price appreciates as on date of cancellation as

compared to the spot rate on date of booking the contract.



MOVEMENTS OF USD/INR SPOT RATE DURING THE PERIOD UNDER

EXAMINATION



Periods when an Exporter could have GAINED on account of Export Fwd

Contract Cancellations :

Period USD/INR Max Depreciation of USD/INR

_____ From - To Max Gains to Exporters (Gross)

5.3.07 – 26.07.07 44.68 40.87 3.81

17.8.07 – 10.10.07 41.34 39.24 2.10

17.3.08 - 17.4.08 40.74 39.79 0.95

6.86



Periods when an Exporter could have LOST on account of Export Fwd

Contract Cancellations :

Period USD/INR Max Depreciation of

USD/INR

_____ From - To Max Loss to Exporters (Gross)

24.7.07- 17.8.07 40.24 - 41.34 1.10

16.01.08- 17.3.08 39.29 – 40.74 1.45

17.4.08 - 27.5.08 39.78 – 42.99 3.21

5.76



OUR CONTENTION

When Forward Contracts were introduced in India, the Gains (if any ) on

account of cancellation of Forward Contracts were not passed on by banks toexporters

Losses (if any) on account of cancellation of Forward Contracts were passed

on to exporters

Earlier system prevented Exporters from speculative activity in the foreignexchange market.

With Liberalisation, Exporters allowed to get gains on Cancellation of

Forward Contracts, which set –off part of the losses on cancellations.

Emboldened by the profits made by booking and cancelling forward

contracts when the foreign currency was depreciating, (against genuine

underlying and genuine cancellation of orders), exporters started engaging in

speculative “Trading Activity”, totally un-connected with their core export

business.

Exporters made multiple –bookings under a single order, using the



OUR CONTENTION (Contd )

The Exporters are not innocent and “gullible” but knowledgeable as

they have been in the exports and foreign exchange business much

longer than bank officers , (who are in an assignment for not more than

3 to 4 years)

While engaging in “Trading “ activities, even a seasoned Foreign

Exchange Dealer in a bank makes a loss. But banks have well –defined

Risk Management policies for cutting losses.

Exporters, while engaging in “Trading Activities” ( with/ without

underlying exports), did not have well –defined Risk Management

policies, resulting in losses , when the USD and other foreign currencies

started appreciating.

Having engaged in these trading activities, the exporters are now

blaming innocent bankers of defrauding them !!



Disadvantages of Forward Contracts

• Locks an Exporter into a fixed rate of exchange

( 1 $ = Rs 39.00 say )

•

• Exporter has to deliver the underlying

whatever may be the Exchange Rate on date

of delivery .



Forward Contract USD/INR as on

delivery date

Fx P/L for

unhedged Exporter

Fx P/L for hedged

exporter1 4

1$ = Rs 39.00 1 $ = Rs 49.00 + Rs 10.00 Nil

1 $ = Rs 29.00 - (Rs 10.00) Nil

3. Loss on cancellation , if spot USD/INRhigher than Rs 39.00 on date of cancellation



Advantages in booking Forward Contracts

1. No upfront fees

2. Fx risk due to currency fluctuation completely

eliminated

3. Profit on cancellation if spot USD/INR lower than Rs

39.00 on date of cancellation



Options

A better hedging tool

• PUT OPTION : Gives the buyer (exporter) the

RIGHT but not the OBLIGATION to deliver (SELL)

the underlying (USD/INR) on a specified future

date at a specified exchange rate fixed now (1 $ =Rs39.00 say ) .

. CALL OPTION : Gives the buyer (importer) the

RIGHT but not the OBLIGATION to take delivery(BUY) underlying (USD/INR) at a specified

exchange rate fixed now (1 $ = Rs 39.00 say )



OPTION PREMIUM

The buyer of the option pays an upfront fee (premium) to the seller of the

Option



Forward contract Put optionLocks in forward rate (at 1$ =

Rs39.00 say )

Unable to enjoy upside ( 1 $ =

Rs 49.00 )

The exporter is under no

obligation to exercise option

and deliver underlying at

contracted rate.

Will exercise Option and

deliver underlying if rate issay 1 $ = Rs 35.00

Will not exercise Option if

rate is say 1 $ = Rs 49.00

Advantage of Put Options over forward contracts for and Exporter



Disadvantages of Options as compared

to Forward ContractsForward Contract Put Option

No uprfront fees for booking contract >Upfront fees payable , depending on

volatility of USD/INR

Upside available only if exchange rate

exceeds fee/premium for buying the

Option.Example : Option Price 1 $ = Rs 39.00

Premium = Rs 2.00

Upside available only if

USD/INR exceeds - Rs 41.00



Why did Exporters prefer Zero Cost

Option Structures ?

Exporters had been booking Forward

Contracts for ages, and there was no fee for

buying this hedging product.

They did not want to pay the Option premium

which would cut into their business profits,

as cost of Option could not be loaded on to

the foreign buyer



Enter – Zero cost Option Structures

Forward Contracts Zero –Cost Option Structure

>Down-side risk protected

>Upside potential limited to the rate at

which forward contract booked

> No Upfront Fees

>Down side protected with Exporter

buying a PUT Option

>Upside limited with Exporter

writing/selling a CALL Option

>Cost of Put Option set-off by premium

received by selling a CALL Option.

No net receipt or payment of premium,

hence no upfront fees



Enter – Zero cost Option Structures

Forward Contracts Zero –Cost Option Structure

Cancellation , when spot is lower than

contracted rate, gives profit.

Cancellation of structure, when spot is

lower may not necessarily result in profit,

as Exporter would have to buy a

matching CALL, and the premium is a

function of ‘volatility’, and not a linearfunction.

In the case of Exotic Zero –Cost

structures , the Premium for buying back

the CALL, may be much more than the

favourable movement of the spot.



Some arithmetic of Forwards and Zero

–Cost StructuresForward Contracts Zero-Cost Structures

Exporter books 3 $ forward at 1 $ = Rs

39.00

Exporter buys a Zero Cost Structure:

1 $ PUT @ 1 $ = Rs 39.00

2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1$ = Rs 49.00

Exporter delivers $ 3 at Rs 39.00

Fx P/L ( Rs 49.00 – 39.00 ) = Rs 10.00

On Due date : 1 $ = Rs 49.00

Buyer of CALL excercises option at Rs

41.00

Exporter delivers 2 $ CALL @ 1 $ = Rs

41.00

Exporter does not exercise PUT, and sells

underlying 1 $ @ 1 $ = Rs 49.00

Gain on PUT ( 49.00 – 39.00 ) = 10.00

Loss on CALL ( 49.00- 41.00) = 8.00

Total Loss ( 1 * 10) – ( 2*8) = ( 6)






39.00


1 $ PUT @ 1 $ = Rs 41.00

2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1$ = Rs 49.00

Exporter delivers $ 2 at Rs 39.00

Fx P/L ( Rs 49.00 – 39.00 ) = (-)Rs 10.00

Total Fx Loss ( 2 * 10 ) = (-) Rs 20.00

On Due date : 1 $ = Rs 49.00

Buyer of CALL excercises option at Rs

41.00

Exporter delivers 2 $ CALL @ 1 $ = Rs

41.00

Exporter does not exercise PUT

Loss on CALL ( 49.00- 41.00) = 8.00

Total Loss ( 2*8) = (-) Rs 16






39.00


1 $ PUT @ 1 $ = Rs 41.00

2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1 $ = Rs 29.00

Exporter delivers $ 2 at Rs 39.00Fx P/L ( Rs 39.00 – 29.00 ) = + Rs 10.00

Total Profit : ( 2 * 10.00) = + Rs 20.00

On Due date : 1 $ = Rs 29.00

Buyer of CALL does not excercise optionat Rs 41.00

Exporter sells 1 $ unhedged underlying @

1 $ = Rs 29.00

Exporter exercises PUT, and delivers

underlying 1 $ @ 1 $ = Rs 41.00

Gain on PUT (41.00-29.00) = Rs 12.00

Loss on unhedged underlying (39.00 –

29.00) = Rs 10.00 OR

(41.00- 29.00) = RS 12.00

Total Loss: (1 * 12) – ( 1 * 12) = (-) Rs 0.00

Or Profit : (1 * 12) – (1 * 10) = + Rs 2.00



Conclusions regarding choice between

FC and Zero –Cost OptionForward Contract Zero Cost Option Structure

Most advantageous when :

Spot Lower than Contracted Rate

Most Advantageous when :

Spot Equal to the Forward Contract Rate

Least Advantageous When :

Spot Higher than Contracted Rate

Least Advantageous when :

Spot higher than Strike/Contracted Rate

From April 2007 to Oct 2008 –

USD/INR went up, and contracts booked

at 39.00 were in loss.

Where there are no underlyings , FX Loss

adds to business loss, as corporate has tobuy the underlying in the market and

deliver.

From April 2007 to Oct 2008 –

USD/INR went up, and ZeroCost

Structures booked at 41.00 were in loss






39.00


1 $ PUT @ 1 $ = Rs 41.00

2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1 $ = Rs 39.00

Exporter delivers $ 2 at Rs 39.00Fx P/L ( Rs 39.00 – 39.00 ) = NIL

Total Profit : NIL

On Due date : 1 $ = Rs 39.00

Buyer of CALL does not excercise optionat Rs 41.00

Exporter sells 1 $ unhedged underlying @

1 $ = Rs 39.00

Exporter exercises PUT, and delivers

underlying 1 $ @ 1 $ = Rs 41.00

Gain on PUT (41.00-39.00) = Rs 2.00

Loss on unhedged underlying (39.00 –

39.00) = NIL

Total Fx Profit : (2*1) = Rs2.00

Forward Contracts Explained Simply

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